Wall Street research is useful . . . from a contrary perspective

I have been observing Wall Street "sell-side" research for many years now. Frankly, I find it is predominately useful from a contrarian perspective. This past Monday (Oct. 27), a Goldman Sachs (GS) research opinion hit the wires and provided, in my opinion, a classic example of the short term, myopic mentality that is prevalent in the Wall Street brokerage community. So, I thought I'd share.

Analysts who work for Wall Street brokerage houses are called "sell-side" analysts.  They sell their research to the "buy side" i.e., asset managers, mutual funds, pension funds, etc., in exchange for directed trading (commission revenue) through their respective firm's trading desks. While there are plenty of smart analysts who work on the sell side, one criticism of the sell side is that access to management is often more important than forecasting accuracy. In fact, there are very few "sell" ratings on covered companies on the sell side because analysts don't want to get "black listed" by company management.

This is also why you have various "soft" ratings system on the sell side. For example, a sell side analyst might downgrade a company from "buy" to "neutral" or "overweight" to "market weight." Outright "sell" recommendations are very rare and usually happen prior to the broker dropping coverage on a stock all together.  

They also have "price targets" which are typically derived from forecasts of earnings and price-earnings multiples, which are estimates of what investors might be willing to pay for $1 of a company's earnings. Intrinsic value, derived through the assessment of the worth of a business based on discounted cash flow analysis, is virtually unheard of on the sell side. We prefer discounted cash flow analysis because of its longer term modeling, and management cannot manipulate cash flow as easily as earnings.

Foresight or hindsight?

Monday, an analyst at GS issued a forecast for crude oil of $74 per barrel and downgraded nearly every energy company he covers. This caused energy stocks, which rallied nicely the prior week, to sell off yesterday. Fifteen energy companies were almost all downgraded from "Buy" to "Neutral" and price targets were slashed across the board. Only one company was deemed a "sell."

The only company on the list we have purchased for our clients was Halliburton (HAL). It was removed from the firm's "Conviction List" but maintained a "Buy" rating with a price target lowered to $65 from $87. The stock closed at $55.70 Monday. We believe its previous target was way too high based on a longer term discounted cash flow projection using normalized, conservative energy prices, and its new target is moderately too low.

My main problem with this forecast and downgrade is that it would have been much more useful to an investor a month ago than Monday. The market began to price in the prospects of a near term oil glut more than a month ago. The new price targets of the covered GS energy companies are much closer to their respective 52-week lows than 52-week highs!  When the stock of a viable company generating cash flows goes down, its long term expected return increases.   

Certainly, more downgrades from the sell side are possible, and we may not have seen the bottom yet for the energy sector. But sell side downgrades based on short term outlooks, to us, are contrary indicators and create opportunities to examine companies more closely for purchase, not sale.

Dana L. Crosby, CFA, CFP®

High Frequency Trading

High Frequency Trading (HFT) has been a popular topic in recent years, and the most recent edition of the Financial Analyst Journal published an editorial by Larry Harris, CFA, a finance professor at USC's Marshal School of Business, which discusses the types of HFT that are beneficial to capital markets and that which are harmful.  We posted a link to the article here.

Regulators must be careful to not take actions that could hinder market liquidity.  Mr. Harris discusses the "technological arms race" between HFT firms, the harm to market liquidity if someone wins that race, and steps regulators can take to prevent someone from winning that race.

Compelling valuations in energy

There is an element of luck in any investment strategy, both good and bad.  In Covered Call writing, the timing of trading before and after options expiration can sometimes work for you or against you.  We have had some unique challenges this year with the first quarter capital markets posting strong results and having to make reinvestment decisions post options expiration.  We wanted to discuss a few positions and our strategy going forward.

In February, we had some energy positions called away profitably.  With talk of a summer gas spike occurring, we did not want to risk being out of energy stocks because profit margins of energy stocks generally increase when oil prices rise.  So, we fairly quickly re-established these positions shortly after options expiration in February.  However, later in February, reports of the ill effects of higher energy prices on weak economies around the globe became the focus and sent energy futures prices, and energy stocks, down. 

The cyclical energy sector then became a primary target for the risk shedding that occurred after the elections in Greece and France triggered the current “risk off” environment we wrote about in our previous post.  As a result, the energy sector is the worst performing sector of the S&P 500 year-to-date through June 8. 

In some accounts we also own Halliburton (HAL), a premier oil services sector company.  This sector has declined in sympathy with the price of oil but has also been affected by a price spike in a compound used in the fracturing process that has put more pressure on margins.  The stock closed at $27.96 on Friday. 

We believe the energy sector in general is one of the most undervalued sectors, and HAL is extremely cheap, trading at a PE ratio of nearly half of its 5-year average (8.3 vs. 15.5) and only 1 times sales.  The analyst consensus price target for HAL is $46.  We received some confirmation on our opinion this morning when Goldman Sachs issued a forecast for a 29 percent rise in commodity prices over the next 12 months to be led by the energy sector.  (We do find, however, the extreme confidence of these specific point estimates of Wall Street forecasts somewhat amusing.)

Also, OPEC meets later this month, and the Saudis are going to be under pressure to cut their production.  A number of the smaller OPEC members are facing production costs that are currently higher than the current spot oil price.  Our approach after June options expiration is to write calls on energy positions using options further out-of-the-money, if we sell options at all, to capture the upside of this undervalued sector.

On the positive side, our largest portfolio exposure is in the information technology sector which leads the S&P 500 Index year-to-date, and we’ve been able to buy back June options and roll down to lower June strike prices on numerous positions including energy stocks/ETFs for many accounts.  Despite a positive week for most equity markets last week, we don’t believe this is the start of a “risk on” environment as too much uncertainty exists with elections in Greece occurring after June options expiration next weekend.  However, news that euro zone finance ministers agreed to lend Spain 100 million euros to help the country’s shaky banks reduces the risk of contagion.  We believe a “risk on” environment could come sooner rather than later once there is more clarity with the political situation in Greece.

As always, please contact us if you have any questions.

May 2012 Ushers In “Risk Off”

Since the financial crisis of 2008, some new financial terminology has evolved to describe market timing trading activity by large institutional investors like hedge funds.  This trading has contributed to increased correlations among traditional equity asset classes and is an annoyance to long term investors.

The trading is usually triggered by systemic events or news and is termed “Risk On” and “Risk Off.”  Risk Off means global macro traders sell and even short sell riskier assets like equities and commodities and buy U.S. Treasury bonds and safe-haven currencies like the U.S. dollar.  When these traders go Risk On they do the opposite, buying equities, certain commodities, and currencies and short sell Treasuries and other currencies.  Since the beginning of May we have witnessed another period of Risk Off, triggered, once again, by news out of the Eurozone. 

A few weeks ago, France and Greece voted Socialists into power, calling into question the bailout austerity agreements in place for Greece.  (These austerity agreements, incidentally, had caused the Risk On bull market condition starting in October 2011 through March of 2012.)  The elections of socialists increased the risk that Greece will fall out of the European Union, the ramifications of which are highly uncertain and possibly chaotic.  Markets hate uncertainty, and the uncertainty with our own budget deficit, debt, JP Morgan proprietary trading losses, and Presidential election cycle don’t help, nor does the much-anticipated Facebook IPO falling flat on its face.

The 10-year Treasury bond yield has fallen to as low as 1.7% during the latest Risk Off period, and the energy sector has gotten hammered right after expectations of a heavy summer driving season drove gas prices up. 

Our strategy

Obviously, Risk On and Risk Off traders have had an impact on volatility in global capital markets.  The one saving grace for us is that options premiums have increased.  We have been able to buy back many of our June options positions profitably and have been able to “re-write” some June options at lower strike prices.  Otherwise, since nearly all of our May options positions expired out-of-the-money, we would like to see a bounce in the markets before establishing the rest of June and July options positions.

We have international equity exposure through ADRs and broad-based asset class ETFs that mimic the MSCI EFAE (EFA) and MSCI EAFE Value indexes.  EFA has nearly 1,000 companies whose largest holding is Nestle SA which has a PE ratio of 5 according to Morningstar.  BP PLC also has a PE ratio of 5.  The majority of the country exposure is Great Britain, Japan, and Australasia.  It does have some bank exposure, but we believe most of the bad news is already priced in to the international banking sector.  We think panic selling an entire asset class when valuations are this compelling is a mistake, particularly when we can generate 1.2-2% in call option premium on June expirations.

One day, we believe this crisis will be history, but no one knows when that will be.  We are watching the situation in Europe closely.   Greece and France are attempting to form coalition governments in June, and euro-zone officials are contingency planning for Greece falling out of the Euro.  We believe every effort will be made to prevent that from happening but have read some reports that that would not necessarily be a bad thing either.  We think at some point there is a likelihood our global-macro traders will be Risk On.

We will keep you informed, and, as always, don’t hesitate to call.

Asset class returns

The chart below represents capital market returns for the calendar year 2011.  Where would you have put new money on January 2, 2012?

Often, investors project past performance forward and avoid the asset classes with recent negative returns.  As it turns out, January would have been a great month to rebalance, i.e. sell asset classes with the best returns and buy asset classes with the worst, as the performance of the first two months of 2012 show.  The worst became the best:

While capital markets returns in the short term are unpredictable, periodic rebalancing a portfolio back to targeted weights acts as a disciplined, unemotional strategy to help buy low and sell high.  Since no one knows what asset classes will perform the best and when, periodically rebalancing a portfolio at set intervals—monthly, quarterly, semi-annually, or annually—is an institutional practice that makes sense for individuals as well.  --D. Crosby, CFA, CFP©

*Data source: Interactive Data.  Indices in order: S&P 500, Russell 2000, Dow Jones U.S. REIT, MSCI Developed EAFE, MSCI EAFE Small Cap, MSCI Emerging Markets, Barclays Intermediate Government, U.S. Treasury Bills.